Best Bets? Bonds

SAVVY INVESTOR

Outperforming Stocks As Of End Of August

Slow and steady is winning the race in 2000, as bonds -- the tortoise of the securities markets -- have outpaced all major stock indexes during the first eight months of this year.

The 10-year U.S. Treasury note delivered an 8.9 percent total return through the end of August. The Standard & Poor's 500 index, by comparison, has returned 4.1 percent during the same period; the Nasdaq composite -- though up 31 percent from its lows in late May -- returned just 3.5 percent through Aug. 31.

If bonds maintain their lead for the rest of this year, this will mark the first time since 1990 that bonds have outperformed stocks. Even if stocks overtake bonds for the balance of this year, conditions seem ripe for a continued bond rally, several analysts say.

The rise in bond prices has come in spite of six fairly recent moves by the Federal Reserve to raise the interest rates it charges on loans to member banks. Bonds are interest rate-sensitive investments. Prices of bonds typically rise when interest rates fall, and fall when interest rates rise. Interest rates typically rise during periods of rising inflation.

Despite the existence of economic forces once regarded as inflationary, inflation has lately held steady -- and bond prices have consequently floated upward.

Bonds have also benefited from the shrinking government budget deficit. The shrinking deficit has reduced the need for the government to borrow money -- and thereby reduced the supply of bonds, and pushed up prices.

``The government's financial position has never been more favorable, and this has given a tremendous lift to the bond market,'' said Umesh Patel, manager of the Phoenix-Seneca Bond Fund (ticker symbol: SAVAX).

``There is a sense of urgency with long-term Treasury bonds. People are scrambling to buy them,'' said Mario DeRose, chief fixed-income analyst at Edward D. Jones & Co. in St. Louis.

Last year, DeRose noted, bonds -- including government bonds -- accounted for just 20 percent of the sales at Edward D. Jones' retail business at its 5,100 offices around the United States. This year, DeRose said, bond sales account for 40 percent of total sales.

``The air is different now,'' agreed John Moran, head of the retail bond department with Advest Group in New York.

``Some are buying bonds to rebalance portfolios overweight with stocks. And some with cash are devoting some of that money to bonds, instead of putting it all in stocks, as they did last year,'' Moran said.

In decades past, rising oil prices often led to higher inflation -- and higher interest rates that battered bond prices.

But during the past 12 months, oil prices have risen from about $23 to almost $35 a barrel. Although consumers are paying more for gasoline, and the major shipping and airline companies have added a second surcharge this year on the goods and passengers they transport, inflation remains largely in check.

``The New Economy bears little resemblance to the oil-driven economy of the 1970s. It is much more flexible and resilient,'' Patel said.

Low unemployment has also refrained from being the inflationary force that it once was, Patel said. This newly discovered fact of life, too, has helped the bond markets.

The so-called Phillips Curve, for example, held that there was an inevitable trade-off between inflation and unemployment. As unemployment fell, wages would rise and inflation would rise, the theory said, while rising unemployment would eventually push down wages -- and inflation. Falling inflation would encourage the Fed to lower interest rates, which would eventually give even a greater boost to bond prices.

The Phillips Curve theory appears dead today. The annual rate of inflation hovers near 3 percent; the annual rate of unemployment is about 4 percent. Yet inflation appears to be under control, so the bond market rally continues, said Patel, whose Phoenix-Seneca Bond Fund has advanced 6.9 percent a year during the past three years.

Investors have reacted to the low-inflation, low-unemployment and low-interest rate environment with their feet -- and checkbooks. According to firms that track mutual fund cash flows, investors this year, compared with last year, have devoted a greater portion of their newly invested cash to bonds.

Some have bought directly from the U.S. Treasury via the Treasury Direct program; some have latched onto the newly issued I-Bonds, or so-called inflation-protected securities; some have bought government, corporate or agency bonds through a broker; and some have bought bond mutual funds.